BOND PRICE VARY INVERSELY WITH INTEREST INCOME

SUBMITTED TO: PROF.RAMAKRISHNAN

SUBMITTED BY : HARSHUL BAKHRU ROLL NO-24 SECTION-FN4 SESSION-SS08-10

Bond market price
y The market price of a bond is the current value the market places on a particular debt issue. y The market price of a bond is a function of interest rates, the issuer's financial condition, and buyers' interest.

Relationship between bond price and interest rate
y The price of a bond is nothing but the present value of the future cash flows. y Future cash flows in case of bonds are the periodic coupon payments that the investor will receive. y P = A / (1 + r)t,

where P= present value, A=future cash flow, r=coupon rate of the bond, t=no. of years.

Yield to Maturity
y Rate at which present value of future cash flows equals the current market price. y Given price, YTM can be calculated through iteration. y Given YTM, price can be computed, using the YTM rate to discount the future cash flows. y An important factor in bond pricing y This is rate applied to the future cash flow (coupon payment) to arrive at its present value.

Yield to Maturity (YTM).
y If the YTM increases, the present value of the cash flows will go down. y This is obvious as YTM appears in the denominator of the formula, and we know as the denominator increases, the value of the ratio goes down. (r is replaced by YTM) y Thus if all the present values go down (due to increase in YTM), then their sum will also go down. This brings us to an important relation y As interest rates go up, bond prices come down.

Price and Yield
y Increase in rates reduces value of existing bonds. y Decrease in rates increases value of existing bonds y Price and yield are inversely related y The relationship between yield and tenor can be plotted as the yield curve.
Yield Curves

Yield Curves

The above chart represents the relationship between the price of a bond to its yield. As the yield rises the price goes down and vice versa.

example
y Let us say a bond is issued with a term to maturity of 3 years, coupon of 8% and face value of Rs. 100. Obviously, the prevailing interest rates during that time have to be around 8%. If the prevailing rates are higher, investors will not invest in a 8% coupon bearing bond, and if rates are lower, the issuer will not issue a bond with 8% coupon, as a higher coupon means higher interest payments for the issuer.

Now, if interest rates in the market rise immediately to 9% after the bond is issued, we will have to use 9% as the rate of discounting (investors would like to earn 9% from this bond). In that case the cash flows and their PVs will be :

As can be seen, the investor will invest less today, i.e. the price of the bond will go down as the interest rates in the markets have increased.

conclusion
y Bond prices vary inversely with market INTEREST RATES. Because the stream of promised payments usually is fixed no matter what subsequently happens to interest rates, higher rates reduce the present value of these promised payments, and thus the bond price.

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